Monopoly, Price Discrimination & Public Policy – Detailed Study Notes

Introduction & Context

• 1990s personal-computer market dominated by Microsoft Windows
  • Windows protected by U.S. copyright ⇒ exclusive right to copy/sell
  • Retail price ≈ \$100 even though marginal cost of one extra download ≈ \$0
  • Microsoft therefore labelled a monopoly in “Windows-compatible OS” market
• Competitive‐market model (previous chapter)
  • Many firms, identical products, each is a price taker
• Monopoly model (this chapter)
  • Single firm with no close substitutes ⇒ price maker
  • Charges P>MC, sets own price–quantity point on market demand curve
  • High prices constrained because higher P ↓ quantity demanded (buyers switch, forgo, or pirate)
• Societal ramifications
  • Competitive equilibrium promotes welfare “as if guided by an invisible hand”
  • Monopoly outcomes often inefficient (under-production, over-pricing)
  • Governments can intervene (e.g., blocked Microsoft–Intuit merger 1994; browser tying 1998; current scrutiny of Apple, Google, Amazon)

16-1 Why Monopolies Arise

• Definition: A firm is a monopoly if it is the sole seller of a product without close substitutes
• Core cause: Barriers to entry preventing potential competitors
  1. Monopoly Resources
  • Exclusive ownership of key input (e.g., lone water well in small town)
  • DeBeers once controlled ≈ 80 % of world diamond output
  • Rare in large, global modern economies
  1. Government Regulation
  • Legal monopoly via patents, copyrights, business licenses
  • Patents (≈20 yrs) encourage R&D (pharma), copyrights encourage creativity (authors)
  • Trade-off: higher innovative incentive vs. monopoly pricing costs
  1. Natural Monopoly
  • Economies of scale over entire relevant output range ⇒ ATC continually falling
  • One firm can supply market at lower cost than multiple firms
  • Example: municipal water network, uncongested toll bridge (club good: excludable, non-rival)
  • Market size matters: growing demand can erode natural-monopoly status (e.g., need second bridge once traffic congested)

16-2 Production & Pricing Decisions of a Monopoly

Monopoly vs. Competition

• Competitive firm faces horizontal (perfectly elastic) demand ⇒ P=MR
• Monopolist faces market demand (downward sloping)
  • Choosing higher Q forces lower P for all units

Revenue Relationships

• Key table (water example) shows:
  • AR = \frac{TR}{Q} = P (always)
  • Marginal Revenue MR < P after first unit because of price effect on existing units
• Two opposing effects when monopoly raises output 1 unit
  1. Output effect: +1 unit sold ⇒ +P to revenue
  2. Price effect: Price drop \Delta P<0 applies to all prior units ⇒ revenue loss

Profit Maximization

1. Derive MR from demand
2. Find quantity where MR = MC ⇒ Q_{MAX} (point A)
3. Move up to demand curve ⇒ monopoly price P_{M} (point B)
4. Comparison
   • Competitive: P=MR=MC
   • Monopoly: P>MR=MC

• No supply curve exists for monopoly (quantity depends on demand curve as well as costs)

Profit Size

• Profit = TR - TC = (P-ATC)\times Q
• Graphically: rectangle with height (P-ATC) and width Q_{MAX}

Case Study – Drugs

• During patent ⇒ firm is monopolist ⇒ P{mono} \gg MC, Q{mono} where MR=MC
• After expiration ⇒ competitive entry drives P \to MC, quantity rises
• Brand loyalty lets former monopolist keep charging premium over generics (e.g., Prozac® vs. fluoxetine)

16-3 Welfare Cost of Monopoly

Benchmark: Social Planner

• Efficient quantity where Demand = MC (value to buyers = cost to seller)
• Planner would set P=MC and produce Q_{efficient}

Deadweight Loss (DWL)

• Monopoly produces Q{M} < Q{efficient} and charges P_{M} > MC
• Triangle between demand and MC from Q{M} to Q{efficient} measures DWL
• Analogy: Like a tax wedge; but revenue accrues to firm not government

Are Monopoly Profits a Social Cost?

• Transfer of surplus from consumers ⇒ producers; does not reduce total surplus by itself
• Social loss stems solely from DWL (missed trades) plus any extra resources spent preserving monopoly (e.g., lobbying)

16-4 Price Discrimination

Definition & Preconditions

• Selling same good to different buyers at different prices without cost justification
• Requires market power & ability to segment buyers, prevent arbitrage
• Impossible in perfect competition (price takers)

Parable: Readalot Publishing

• Costs: \$2 m fixed, zero marginal cost
• Two segments: 100 k fans (WTP \$30), 400 k casual (WTP \$5)
  • Single price ⇒ choose \$30, sell 100 k, profit \$1 m, DWL \$2 m
  • Price discriminate by geography (Australia vs. U.S.): fans pay \$30, casuals \$5 ⇒ profit \$3 m, DWL 0

Three Key Lessons

1. Rational profit-maximizing strategy
2. Requires customer separation (age, location, stay-over Saturday night, etc.) & limited arbitrage
3. Can increase total surplus, potentially eliminating DWL; however gain may accrue entirely to producers (consumer surplus ↓ or = 0)

Perfect Price Discrimination (PPD)

• Monopolist knows each individual’s WTP and charges it
• Outcome
  • All mutually beneficial trades occur ⇒ no DWL
  • Consumer surplus =0, total surplus = producer profit (panel b in Figure 9)

Imperfect Discrimination

• Real-world group pricing ⇒ welfare effect ambiguous (can ↑, ↓, or stay same vs. single-price monopoly)
• Always ↑ firm profit

Common Examples

• Movie tickets: child/senior discounts
• Airlines: Saturday-night-stay rule separates business vs. leisure
• Coupons & “special-day” online deals: self-selection by search effort/income
• University financial aid: tuition list price + need-based aid
• Quantity discounts: lower P for additional units to same buyer (e.g., 2-for-1)

16-5 Public Policy Toward Monopolies

Policy Options

1. Promote competition (antitrust)
2. Regulate monopolist behaviour (set price, etc.)
3. Public ownership
4. Do nothing (if costs of action exceed benefits)

Antitrust Laws

• Sherman Act 1890; Clayton Act 1914
• Powers: block or reverse mergers, break up firms, prohibit collusion
• Horizontal mergers (same stage) scrutinized more than vertical
• Must weigh lost competition vs. efficiency synergies (cost reductions)
• Cost–benefit judgment often controversial

Regulation (brief mention)

• Government agencies may set prices (e.g., utilities) so that P \approx MC or P=ATC

Public Ownership

• Government runs natural monopoly (e.g., USPS, municipal utilities)
• Economists often prefer private ownership with regulation because:
  • Profit motive disciplines cost control
  • Political oversight less effective than market incentives
  • Risk of public-sector inefficiency & special-interest capture

Key Mathematical & Graphical Relationships

• MR = \frac{\Delta TR}{\Delta Q}; for monopoly MR<P when demand slopes downward
• Profit condition comparison
  • Competitive: P = MR = MC
  • Monopoly: P > MR = MC
• Profit magnitude: \text{Profit} = (P - ATC) \times Q
• Deadweight loss (area): \frac{1}{2}(P{M}-MC)(Q{efficient}-Q_{M}) (triangle)

Ethical & Practical Implications

• Patents/copyrights balance innovation incentives vs. short-run pricing power
• Price discrimination can appear unfair but may widen access (e.g., student discounts)
• Antitrust policy must balance protecting consumers with encouraging productive efficiency via synergies
• Public ownership debates raise questions of governmental accountability vs. market discipline

Connections to Prior Principles

• Revisits Ten Principles: “Governments can sometimes improve market outcomes”
• Ties welfare analysis (Chapter 7) to real-world market structures
• Extends cost curves & marginal analysis (Chapters 11 & 14) into imperfect-competition context

Quick Concept Checks (from in-text quizzes)

• Monopoly produces too little at too high a price vs. social optimum
• DWL arises because some buyers value good > MC yet abstain due to high P
• For single-price monopoly: correct relationship ⇒ P>MR=MC
• Fixed-cost changes alter profit but not optimal P/Q
• Price discrimination bases adjustments on willingness to pay, not race/ethnicity or cost differences
• Perfect price discrimination eliminates consumer surplus and DWL